The resistance to the rise in interest rates on business loans

By Leonidas Stergiou

Cheap deposits, the end of negative interest rates by the ECB and strong demand in business loans, which generate the largest volume and value of new NPL production for banks, are the three main reasons holding down funding costs for businesses in a rising interest rate environment.

The reasons for the containment of upward trends in business loan interest rates are mainly three:

First, the high demand for loans, refinancing and investments, with a negative real interest rate, combined with the relatively limited number of businesses that can be financed. Almost 90% of new loans and refinancings amounting to 16 billion euros in the first half were related to business credit. In other words, the main volume of banking business comes from the business sector, due to ongoing deals, investment plans, privatization program and €20 billion capital raising by 2022. Rising inflation and production costs, especially in energy and industries affected by it, soared the demand for working capital. Thus, according to the banks, there is at least another €10 billion left to meet the demand for business capital until the end of the year, which will probably not be met and will create a “cushion” for 2023.

Secondly, the cost of negative ECB interest rates no longer exists. Instead, they will start earning. Until the first increase in interest rates by the ECB in July, banks were depositing the excess liquidity of deposits amounting to around 50 billion euros at a negative interest rate (-0.50%). This rate is currently zero and is expected to reach 1.5% by the end of 2023, based on current market trends. The rise from -0.50% to 1.5% will bring additional revenue of at least 800 million euros to the four systemics alone. This amount can be used to boost profitability, build capital and also as a “cushion” for competitive interest rate policies in categories that want to gain share or that are more profitable (eg mortgage and business loans).

Thirdly, cheap financing from deposits. No matter how much the interbank or ECB interest rates rise, a smaller portion will go to deposits and interest rate increases will be slower as long as there is excess liquidity. Today, for example, the total loans of the four systemic banks amount to 145 billion euros and they have deposits of 207 billion euros. Therefore, there is room for significant credit expansion at a cost equal to the deposit rate plus provisions (around 14 euros for every 100 euros loan).

Already, the four systemic only with a decrease of 0.01 of a point in deposit rates, an increase of about 30 basis points in business and by 12 basis points in housing managed to increase net interest income by 81 million euros in one quarter ( April-June, compared to the first quarter), to reduce expenses for interest payments by 1 million and to increase income from interest collections by 94 million euros.

Euribor in positive territory

And all this before the ECB’s interest rate hike in July, except with the increase in Euribor and bond yields. The 3-month Euribor interbank rate rose from -0.53% in Q1 to -0.36% in Q2. The 6-month Euribor from -47% in the first quarter, moved into positive territory (0.10%) in the second quarter. It is noted that only the 1-month Euribor remains marginally negative (-0.016%), while the 3-month Euribor has risen to positive territory since July.

Bond yields

With regard to bonds, whose yields mainly affect loans with fixed interest rates (e.g. mortgages), it is noted that banks do not do credit hedging on bonds, but yields. This means an interest rate swap. That is, they give the counterparty theirs and collect from the counterparty (swap). Since they do not sell the Greek bonds, they do not write losses from the drop in prices. Instead, the rise in yields is converted into a profit by the difference between the yields of the market and the swap where it is closed. These moves and a general uptick in banking increased trading revenue by about 6%-7% for the four systemics in three months (Q2). Nevertheless, in the second half, due to uncertainty in the markets and due to the intervention mechanism of the ECB, there may not be significant profits from bond transactions. They may arise, however, from other types of transactions (exchange, energy prices, etc.).

High demand for funds from businesses

Strong demand and large amounts per disbursement in business credit were the two main reasons driving up loans to the corporate sector in the first half. According to data from the Bank of Greece, the average interest rate on business loans increased in the second quarter by 34 basis points, much more than the rise of the Euribor, which in the 3-month period remained negative, while in the 6-month period it moved into positive territory. This increase came mainly from new loans with regular maturities of more than 1 million euros (which are the majority), whose average interest rate increased in the second quarter by 42 basis points, compared to the first quarter. On the contrary, marginal increases or even lower interest rates are observed in open-term (credit lines) and long-term loans.

According to bank executives, the 34 basis point rise in business loans in the second quarter would have been even larger if two key reasons did not come together. First, a small number of businesses that meet banking criteria and financing through the Recovery Fund. Secondly, two speeds of the economic cycle in the Greek economy. An upside with less risk for the business sector (large enterprises) due to the launched investments and the Recovery Fund. Second, another one, that of private individuals which is burdened with higher uncertainty about disposable income and, consequently, entails a higher credit risk.

Temporary reductions in consumer goods

Nevertheless, in the second quarter, interest rates on open term consumer loans decreased by 37 basis points and on fixed term loans by 22 basis points. The decline is due to strong demand for consumer loans reaching mortgage levels, with the latter showing signs of fatigue. Thus, the banks gave (and are giving) a share battle in consumer credit, which has the highest profit margins, the highest risk, but also the smallest amounts per disbursement. That is, the lowest risk per loan. The second reason is related to the general repricing of retail loans. The third is more technical and is related to the short-term financing of open loans. So while these loans (credit cards, overdrafts, etc.) are considered to have the highest risk, the amounts are smaller (so the bank’s overall risk in terms of total lending is lower) and these amounts are financed with zero cost from deposit liquidity. Therefore, an average interest rate in this category at 16% (credit cards) justifies and covers the risk for an aggressive pricing policy (e.g. a reduction of 10 basis points), despite the rise in interbank rates (financing from deposits with zero interest rates) .

The same applies to business loans with no regular maturities, where, unlike the rest, they showed a marginal rise or fall (in some categories). Also, the general restraint of interest rates on business credit is due to the availability of several co-financed and guaranteed programs (around 1 billion euros).

How will interest rates on deposits and loans increase?

Regarding the next period until the end of the year and possibly until the middle of 2023, at least, the banks foresee the following picture for interest rates on deposits and loans:

– The first rate rises on loans will be felt in consumer credit, due to higher credit risk and the use of cheap liquidity from deposits for more competitive interest rates in housing and business credit.

– In housing loans, the rise will be more noticeable in fixed interest rates, as floating rates will remain at lower levels, due to lower financing costs from interbanking. The credit risk for mortgages (floating and fixed rate) is lower than that of consumers, due to the collateral (property), but higher than that of businesses. Fatigue is noted in mortgage demand and real estate market mobility. Particularly high prices are observed in purchases and rents in certain areas and purchases and sales with equity, rather than mortgages, consistently prevail. However, mortgage lending remains a share battleground among banks as portfolio quality improves and organic credit growth strengthens. It is estimated that a difference of at least 2.5 points will be maintained between floating and fixed interest rates. This practically means that if by 2023, the key ECB interest rate has risen to 1%, then the floating rate will be close to 4%-4.5% and the fixed rate to 6.5%-7%.

– Deposit rates will see the first noticeable increases after the ECB’s key rate rises above 50%. Then, a small part of the increase will go to deposits and the rest (which is not transferred) will be used as a margin to hold down interest rates on mortgages and mainly on business.

– Business loan rates will be the last to see significant increases, after margins on deposits, ECB interest rates and fee gains are exhausted due to advisory, refinancing and capital raisings. Rising interest rates, inflation and uncertainty have made raising funds from the markets (bonds and stocks) more difficult for businesses. Thus, there will be refinancing and new needs that will be covered by bank lending (in addition to the needs for working capital). Furthermore, as long as the real cost of borrowing is negative (nominal interest rate minus inflation), the demand for bank lending will be boosted by firms for both investment and working capital. All of these operations boost net organic interest and fee income. Banks estimate that under current conditions interest rates on business credit will show stabilizing trends or marginal changes even until mid-2023.